Friday, January 28, 2011

The Allure of Active Management. . .

What is so alluring about active management? Well. . .it really is quite simple. Active management attempts to offer the ability to outperform a market, or a segment in the market, as measured by an index benchmark.

Meaning. . .in an index fund you are constantly holding all of the "good" stocks and the "bad" stocks. Active management, obviously, aims to select only those stocks which will do well and then stay away from the stocks which will perform poorly. And of course, if all of the stocks in the market were to crash, the intelligent fund manager would know ahead of time and pull the money in the actively managed fund out of stocks before investors lost money, thus proving the merit of active management. Would this be a good investment strategy?

Yes. . .in fact, sign me up! In fact, let's not stop there. Since the active fund manager knows when the markets will enter a period of poor performance, we might as well ask him what the nights winning lottery number are! And let's not stop there. . .I'd like to know. . .who's going to win the Super Bowl?

Ok, I'll stop right there. . .I'm being silly. . .

. . .In theory, it would be the prudent thing to do. After all, why would you want to invest your money in stocks that are going to perform poorly, especially when you knew ahead of time that they were going to fall in value?

Answer: You wouldn't. . .

The Truth: Sadly, it doesn't work like this. Active management simply gives the illusion of being able to outperform the market. When you look at the facts, the truth finds its way to the surface. . .

I'll leave you with a quote by the founder and retired CEO of The Vanguard Group, John Bogle as he commented on the lack of success of active fund managers.

"Of the 355 equity funds in 1970, fully 233 of those funds have gone out of business. Only 24 outpaced the market by more than 1% a year. These are terrible odds." (2007)